Derivatives Sample Questions - CFA L1 - Exams

1) Question:

Which of the following statements is (are) true with respect to valuing option contracts?

I. The time value of both a call and a put will decrease as the contracts near expiration.
II. For a call to be at the money, its intrinsic value must be greater than zero.
III. Due to the efficiency of the options markets, the actual price of the option is usually equal to its intrinsic value.
IV. For a put contract to be out of the money, the actual price of the underlying asset must be greater than the strike price of the option.

A) III only
B) I, II and III only
C) II, III and IV only
D) I and IV only

2) Question:
Your research department has just made a sound presentation arguing that the equity markets are due for a severe correction in the short term. Which of the following strategies would be most suitable for safeguarding the portfolio that you manage?

A) Long futures contracts on an equity index
B) Construct a bull-call spread
C) Buy call options on an equity index
D) Buy put options on an equity index

3) Question:
Which of the following are not features of a futures contract?

A) Initial margin deposit is required irrespective of whether you long or short a contract.
B) A long position may be offset by shorting the exact same contract.
C) Daily settlement
D) Only the contract size and the futures price is set by the market participants.

4) Question:

Which of the following statements are true with respect to the treatment of nonrecurring items and discontinued operations?

I. Unlike U.S. GAAP, IAS GAAP does not require the separate reporting of regular earnings, earnings from discontinued operations and extraordinary items.
II. Both IAS GAAP and U.S. GAAP have the same requirements for classifying a transaction as an extraordinary item.
III. Losses from discontinued operations must be reported under U.S. GAAP when it can be reasonably estimated, whereas IAS GAAP requires that these losses be reported only when they are realized.
IV. According to IAS GAAP, the correction of an error may only be accounted for by restating prior period statements.

A) I and III only
B) III and IV only
C) I and IV only
D) II, III and IV only

5) Question:
ABC Company just entered into an interest rate swap agreement with another company. ABC has agreed to make semi-annual payments at a fixed rate of 7.6% per year. The counterparty, on the other hand, has agreed to make variable payments at a rate of LIBOR + 1. With a notional principal of $15 million, which of the following statements would hold true for the first payment in six months if LIBOR were 6.1% today and 6.9% in six months?

A) ABC would receive a net payment of $37,500.
B) ABC would receive a net payment of $22,500.
C) ABC would have to make a net payment of $22,500.
D) ABC would have to make a net payment of $37,500.

6) Which of the following statements is false with respect to derivative securities that involve a contingent claim?

(a) Sellers of options do not have any control with respect to the exercise of the option.

(b) When selling a call, any claim is contingent upon the buyer exercising the call.

(d) Buying a put exposes the investor to a contingent claim.

7) Which of the following events will lead to an increase in the value of a call option?

(a) A declining time to maturity

(b) Declining price of the underlying asset

(d) An increase in the exercise price

8) Which of the following statements least accurately describes the features of the eurodollar time deposit market?

(a) A dollar-denominated time deposit with a bank in Japan is considered as a eurodollar deposit.

(b) With eurodollar time deposits, all the interest is accumulated and paid one time at the maturity date of the deposit.

(d) LIBOR is the rate that a London bank is willing to pay on deposited funds.

9) Which of the following statements is (are) true with respect to the mechanisms involved in futures trading?

I. A daily price limit is the amount by which the futures price is allowed to move from the opening of the trading session to the close of trading in the same day.
II. When the futures contract is said to be locked limit, it is an indication that trading has ceased.
III. Scalpers usually generate a higher frequency of futures trading than would day traders.
IV. If a delivery option is chosen, the invoice price for the underlying asset will always be equal to the agreed upon futures price times the contract size.

(a) I and IV only

(b) II and III only

(d) I, III and IV only

10) Two parties enter into a three-year interest rate swap, which involves the exchange of LIBOR+1 for a fixed rate of 12% on a $100 million notional amount. The LIBOR rate today is 11%, but is expected to increase to 15% in one year and fall back down to 8% in the following year. Which of the following statements accurately depicts the flow of net cash flows between the two counter-parties?

(a) The fixed rate payer would receive a payment of $4 million at the end of year two, while the variable rate payer would receive $3 million at the end of year three.

(b) The fixed rate payer will have to pay $4 million at the end of the second year and $3 million at the end of the third year.

(d) The variable rate payer would receive a payment of $4 million at the end of year two, while the fixed rate payer would receive $3 million at the end of year three.

Answers

1) The Right Answer is d.
Explanation:
Choice II is incorrect because for a call to be at the money, its intrinsic value must also be equal to zero. III is incorrect because even though the option markets are extremely efficient, the actual price of the option contracts is equal to the sum of the option's intrinsic value and its time value. Only on the expiration date will the actual price of the option be equal to its intrinsic value.

2) The Right Answer is d.
Explanation:
If you expect stock prices to decline, you'll want to enter into an agreement that will allow you to sell shares at a pre-determined price. This way, you are effectively locking in the future value of the shares. There are only two strategies that will enable you to carry out this transaction. First, buying a put will give you the "right" to deliver these shares at a pre-determined price. Second, selling stock index futures will "obligate" you to deliver these shares at a pre-determined price.

3) The Right Answer is d.
Explanation:
With a futures contract, only the futures price is determined by market forces. All other terms, including contract size, is set by the exchange.

4) The Right Answer is a.
Explanation:
Choice II is incorrect because IAS GAAP and U.S. GAAP have different requirements in order for a transaction to be classified as an extraordinary item. IV is incorrect because according to IAS GAAP, the correction of an error may be accounted for either by restating prior period statements, or by including it in the current period's results.

5) The Right Answer is d.
Explanation:

Since the fixed payer owes more than the float payer, only the fixed payer would make one net payment of $37,500.

6) The Right Answer is d.
Explanation:
When buying a put or a call, an investor acquires a right to execute a transaction. Therefore, the seller of these options is faced with the potential contingent claim.

7) The Right Answer is c.
Explanation:
Call Option Value = Stock Value - Present Value of Exercise Price. Consequently, when discount rates increase, the present value of the exercise price decreases, thus increasing the term on the right side, which automatically implies an increase on the left side. Note that in real life, an increase in the discount rate would also have a negative impact on stock values; however, for the purposes of option valuation, the discount rate is only applicable to the present value of the exercise price.

8) The Right Answer is d.
Explanation:
LIBOR is actually the rate at which a London bank is "offering" (or asking) in order to lend funds to other banks. In other words, LIBOR is the higher end of the spread: the ask.

9) The Right Answer is a.
Explanation:
Choice I is false because the daily price limit is the amount by which the futures price is allowed to move from the close of the previous trading session to the close of trading of the current day. Remember that the opening price of the current day is not always the same as the closing price of the previous day. IV is not always true. For some contracts, the "invoice price" for taking delivery of the underlying asset will be based on the futures price, but it may not be the actual futures price itself. For instance, the invoice price might be equal to the futures price times a factor.

10) The Right Answer is b.

Explanation:

End of Yr 1 > Fixed pays ($100 Million * 12%) $12 Million

Variable pays ($100 Million * 12%) $12 Million

= Net Cash Flows received by the fixed payer Nil

End of Yr 2 > Fixed pays ($100 Million * 12%) $12 Million

Variable pays ($100 Million * 16%) $16 Million

= Net Cash Flows received by the fixed payer $ 4 Million

End of Yr 3 > Fixed pays ($100 Million * 12%) $12 Million

Variable pays ($100 Million * 9%) $ 9 Million

= Net Cash Flows paid by the fixed payer $ 3 Million